This paper investigates the macroeconomic challenges for low-income countries created by asurge in aid inflows. It develops an analytical framework for examining possible policyresponses to increased aid, and then applies this framework to the experience of fiverelatively well-governed countries that experienced a recent surge in aid inflows: Ethiopia,Ghana, Mozambique, Tanzania, and Uganda. Each country’s policies were supported by aPRGF arrangement during most of the period under review.

Central to managing a surge in aid inflows is the coordination of fiscal policy withexchange rate and monetary policy. To highlight this interaction, the analyticalframework focuses on two distinct but related concepts: absorption and spending.

• Absorption is defined as the widening of the current account deficit (excluding aid)due to incremental aid. It measures the extent to which aid engenders a real resourcetransfer through higher imports or through a reduction in the domestic resourcesdevoted to producing exports.• Spending is defined as the widening of the fiscal deficit (excluding aid)accompanying an increment in aid.Spending depends on fiscal policy. For a given fiscal policy, absorption depends onexchange rate policy and monetary policy. If the government receives aid-in-kind, or usesaid directly to finance imports, spending and absorption are equivalent. More typically, thegovernment sells aid dollars to the central bank, and uses the local counterpart currency tofinance spending on domestic goods. Absorption depends on the response of the centralbank, with foreign exchange sales influencing the exchange rate and interest rate policyshaping aggregate demand, including for imports. The combination of absorption andspending chosen by an economy defines the macroeconomic response to aid.To absorb and spend is the textbook response to aid; the government increasesinvestment, and aid finances the resulting rise in net imports. Even if the governmentspending is on domestic goods, the aid allows the resulting higher aggregate demand andspending to spill over into net imports without creating a balance of payments problem.Some real exchange rate appreciation may be necessary to enable this reallocation ofresources.

• In the sample countries, however, a full absorb-and-spend response was found tobe surprisingly rare. Typically, there was a reluctance to embrace absorption—andthe consequent real appreciation—due, at least in part, to concerns aboutcompetitiveness.Other responses to incremental aid may be justified under some circumstances and fora limited period of time.

- 4 -To save incremental aid, that is to neither absorb nor spend, may be a good way ofbuilding up international reserves from a precariously low level or of smoothing volatileaid flows.

• In two of the sample countries—Ethiopia and Ghana—absorption and spending wereboth very low. In Ethiopia, reserves were accumulated to bolster the exchange ratepeg against the dollar. In Ghana, a buffer against extremely volatile aid inflows wasbuilt.To absorb but not spend substitutes aid for domestic financing of the governmentdeficit. Where the initial level of domestically financed deficit spending is too high, this canhelp stabilize the economy. Alternatively, this approach to aid can also be used to reduce thelevel of public debt outstanding, crowding in the private sector. When debt reaches lowlevels, however, there are typically limits to the extent to which the financial system caneffectively channel additional resources to the private sector. Further attempts to absorbwithout spending may amount to “pushing on a string,” increasing excess liquidity or evencausing capital outflows rather than increased domestic activity.To spend and not absorb is a common but problematic response, often reflectinginadequate coordination of monetary and fiscal policies. This response is similar to afiscal stimulus in the absence of aid. The aid goes to reserves, so the increase in governmentspending must be financed by printing money or government borrowing from the domesticprivate sector. There is no real resource transfer given the absence of an increase in netimports.

• In Mozambique, Tanzania, and Uganda spending exceeded absorption, creating asurge in domestic liquidity. In Mozambique, this led to high inflation. In Uganda and(initially) Tanzania, treasury bill sales were used to contain inflationary pressure,leading to a rise in interest rates and the domestic debt burden.Spending and not absorbing can lead, over time, to a spend-and-absorb outcome, ifmonetary and exchange rate policies are supportive. The fiscal stimulus potentiallyincreases import demand and hence admits the possibility of greater absorption in a laterperiod. This delayed absorption could then be financed by the accumulated aid. In order forthis mechanism to operate, however, some real appreciation may be necessary, includingthrough inflation if the exchange rate is pegged. Curtailing liquidity through treasury billsterilization could lead to the least desirable result: no absorption of aid, coupled with acrowding out of private sector.

The experience in these cases sheds little direct light on the medium-term implicationsof absorbing and spending aid, mostly because this strategy was not consistentlypursued in the sample. There is no evidence of aid-related Dutch disease in the samplecountries, with the real effective exchange rate remaining stable or depreciating. This is duein large part to the policy decision to accumulate reserves rather than fully absorbing aid—a- 5 -policy typically inspired by concerns about competitiveness and the level of the nominalexchange rate.

In general, targets in PRGF-supported programs appear to be compatible with anabsorb-and-spend response, but the consistency of monetary and exchange rate policywith fiscal policy needs greater attention in cases where the authorities deviate fromthis approach. Fiscal targets accommodate surges in aid, and reserve targets are consistentwith an (aid-financed) increase in the current account deficit. However, where countries areunwilling to follow this strategy—perhaps in order to guard competitiveness—more careneeds to be taken that an appropriate second-best outcome is achieved. In particular, whenrecommending treasury bill sterilization to reduce aid-related money growth, concerns aboutinflation must be balanced against the dangers of failing to absorb the aid and of crowdingout the private sector.

The key long-run strategic choice is whether to use the aid—by absorbing andspending—or not, in which case the aid should be neither absorbed nor spent. The latterchoice, in the long run, is equivalent to forgoing aid, unlike the short run, where it can beused to smooth aid volatility. Thus, it is only appropriate when competitiveness concernsdominate the returns from productive aid-financed investment. In this case, attention shouldbe focused on how, and how fast, to scale up aid so as to minimize competitivenessproblems, for example by focusing on ways to use aid to increase productivity.

- 6 -I. INTRODUCTION

1. Increases in aid inflows allow recipients to increase consumption and investment. Aidpresents an opportunity to reduce poverty, increase the standard of living, and generatesustained growth. However, the effective use of increased aid also presents challenges. Goodprojects must be found and managed, and conditions for budgetary support must be agreedand implemented. The imperative to use the funds well can strain the administrative capacityof recipient governments. In addition, aid flows can weaken ownership, fragment and impairbudgetary procedures, encourage rent-seeking behavior, and undermine the accountability ofdomestic institutions.2. Related to but distinct from these microeconomic and institutional issues are themacroeconomic challenges of managing aid inflows. Aid inflows can cause upward pressureon the real exchange rate to the detriment of the exporting industries that may be critical tolong-run growth. This is fundamentally rooted in the real effects of aid; in other words,microeconomic in nature. But macroeconomic policies can determine how aid is absorbed inthe domestic economy. Aid inflows can also create problems of fiscal management and debtsustainability, particularly when they are volatile and when they come in the form of debt.3. Aid flows to low-income countries have increased somewhat in the past ten years. Ina few relatively well-performing low-income countries, aid inflows have expandedsubstantially from already significant levels. Larger and more widespread increases in aidinflows are seen as critical to achieving the MDGs.1A scaling up of aid will amplify themacroeconomic policy challenges arising from the management of aid inflows. The Fundneeds to confront these challenges squarely in its capacity as a key provider of advice onmacroeconomic policies. Helping countries to manage effectively increased aid inflowswould be one of the Fund’s main contributions to the achievement of the MDGs.4. This paper draws lessons from recent country experiences with the macroeconomicmanagement of large increases in aid inflows.2It is designed to complement the case studiesbeing done by the Fund and Bank and the Millennium Project, which are mainly forward-looking.3The questions this paper will address are:• Do recipients of aid surges encounter macroeconomic absorptive capacity constraints?

• Is Dutch disease a concern?

1A key recommendation of the UN Millennium Project Task Force is to increase official developmentassistance rapidly—at least for a dozen or so fast track countries—to support the MDGs. World Bank and IMF(2005) also advocate a substantial increase in aid to low-income countries.2It was prepared by a team consisting of Andrew Berg, Shekhar Aiyar, Mumtaz Hussain, Shaun Roache, andAmber Mahone.3See United Nations Millennium Project (2005), Bourguignon and others (2005), and Agenor, Bayraktar, andEl Aynaoui (2005).- 7 -• How should fiscal policy be adapted to the aid inflows?

• Are aid inflows inflationary, and what is the appropriate monetary and exchange ratepolicy response? Is there a role for sterilization?

5. While the benefits of higher aid and the challenges of scaling up are frequentlydiscussed, systematic analysis of country experiences is limited.4This paper examines fivelow-income countries that have dealt with these questions over the past decade. Itcomplements existing work in two ways. First, it examines nuts-and-bolts policy questions ofdirect relevance to Fund-supported programs. Second, most existing research is based oncross-country and panel regression analyses, which have limitations for policy purposes,particularly with respect to the scaling up of aid.5While the paper draws on existing research,it will rely mainly on direct evidence from low-income countries that have experienced asurge in aid inflows. Of course, a case study approach carries its own limitations. The smallsample size makes it more difficult to generalize the results to all aid recipients. In addition,it becomes hard to quantitatively (as opposed to qualitatively) control for exogenous changesin the economic environment during the period of increased aid inflows. Finally, long-runeffects may be hard to trace.6. The country studies focus on strong performers defined in terms of institutions andeconomic policies. This permits drawing of lessons relevant for situations in which, broadlyspeaking, policy-making is not dominated by macroeconomic disarray, misgovernance, orpost-conflict reconstruction. The goal is to learn how to help those countries that are well-positioned, institutionally and in terms of the policy framework, to absorb large quantities ofaid. An important number of such countries have emerged in the past decade or so, includingin Africa.6The selected low-income countries satisfy two criteria: first, each (exceptEthiopia) ranks relatively high on the World Bank’s indicator of quality of economicinstitutions and policies (CPIA), and second, each received large amounts of aid in the late1990s and early 2000s, including a surge in aid inflows at some point over the period. The

4For a broad treatment of many of the issues on scaling up aid see Heller (2005) and Klein and Harford (2005).5Critical variables are hard to measure in a broad sample. The regression framework handles only with greatdifficulty the possibility of complex interactions, such as between terms-of-trade shocks, quality of policies, andthe macroeconomic effects of aid inflows. Finally, only a few cases (generally those covered in this study) existof countries that received macro-economically significant increases—several percentage points of GDP—in aidinflows in the context of reasonably strong policies and governance.6See World Bank and International Monetary Fund (2005).- 8 -list of countries that satisfied these criteria and are covered in the paper are Ethiopia, Ghana,Mozambique, Tanzania and Uganda (Appendix I discusses sample selection in more detail).7

7. The paper is centered on the analyses of the country cases. Section II provides aframework for considering the macroeconomic policy response to increases in aid inflows.Section III reports on the country cases. Section IV presents a summary of these findings andimplications for PRGF program design. Section V concludes with some of the broaderlessons that may be drawn about the macroeconomics of increased aid inflows.II. A

MACROECONOMICFRAMEWORK FOR THEANALYSIS OFINCREASES INAIDINFLOWS

8. The macroeconomic impact of aid depends critically on the policy response to aid. Inparticular, it is the interaction of fiscal policy with monetary and exchange rate policy that isimportant. In order to highlight this interaction, it is useful to introduce two related butdistinct concepts: absorption and spending.9. Absorption is defined in this paper as the extent to which the non-aid current accountdeficit widens in response to an increase in aid inflows.8This measure captures the quantityof net imports financed by an increment in aid, which represents the real transfer of resourcesenabled by aid. Absorption captures both the direct and indirect increase in imports financedby aid, i.e., direct purchases of imports by the government, as well as second-round increasesin net imports resulting from aid-driven increases in government or private expenditures.Absorption reflects the aggregate impact of the macroeconomic policy response to higher aidinflows, encompassing monetary, exchange rate, and fiscal policies.10. Absorption can be defined and understood in terms of the balance of paymentsidentity:Current Account + Capital Account = ΔReserves.Breaking the current and capital accounts into their aid and non-aid components, andrearranging items, the following identity is produced:

7It is also critical to understand better how to help low-income countries with weaker performance oninstitutions and policies. The achievement of macroeconomic stabilization has been analyzed frequently, mostrecently in International Monetary Fund (2004) and International Monetary Fund Independent EvaluationOffice (2004). The closely-related institutional and governance issues are discussed in the companionbackground paper (International Monetary Fund (2005b)) and World Bank and International Monetary Fund(2005). Macroeconomic problems in post-conflict situations are discussed in Clément (2005) and InternationalMonetary Fund (2005c).8This usage of absorption should not be confused with the related concept of “absorptive capacity” which, inaddition, involves questions about the rate of return on investments financed by aid.- 9 -Aid Inflows = ΔReserves – (Non-Aid Current Account + Non-Aid Capital Account).9

Thus, an increase in aid can serve some combination of three purposes: an increase in therate of reserve accumulation; an increase in non-aid capital outflows; or an increase in thenon-aid current account deficit. The rate of absorption of an increase in aid is then defined asthe change in the non-aid current account deficit as a share of the change in aid inflows:10

Absorption = Δ(non-aid current account deficit)/ΔAid

For a given fiscal policy, absorption is controlled by the central bank, through its decisionabout how much of the foreign exchange associated with aid to sell, and through its interestrates policy, which influences the demand for private imports via aggregate demand.11Themechanism will depend on the exchange rate regime, but under any regime, the monetaryauthority can choose to accumulate reserves or to make them available for importers.12In theextreme case where the central bank uses the full increment in aid to bolster internationalreserves and does not increase net sales of foreign exchange, none of the extra aid will beabsorbed.

9The non-aid current account balance is the current account balance excluding official grants and interest onexternal public debt, while the non-aid capital account balance is the capital account net of aid-related capitalflows, such as loan disbursements and amortization.10With this definition, aid that finances capital outflows is not absorbed. This makes sense insofar as aid thatflows back out of the country does not transfer real resources to the country. However, there are particularcircumstances in which aid that finances capital outflows can be thought of as allowing an increase inabsorption relative to a particular counterfactual that is relative to what might have happened without the aid.Suppose, say, because of an increase in political uncertainty residents suddenly desire to move capital abroad.The authorities use a large aid inflow to accommodate this capital outflow. Now suppose also that, without theaid, the authorities would not have accommodated this desire with reserve sales but rather would have allowedan exchange rate depreciation. This depreciation might have resulted in a reduction in the trade deficit.Compared to this counterfactual, the aid has allowed a larger trade deficit and hence more absorption. This is anunusual set of circumstances, but it may prevail when reserve levels are very low.11Aid that is directly used to finance imports by the government (e.g., a grant in kind, a grant of foreignexchange that the government immediately uses to purchase imports, or aid that goes directly to NGOs tofinance imports) effectively bypasses the central bank and would lead directly to absorption.12This point may require some further elaboration. Consider, for example, the case where the central bankwishes to ensure full absorption. Assume, for simplicity, that the capital account is closed except for aid. Undera float, the central bank sells all the aid-related dollars on the market, and the agents who buy the dollars spendthem on imports. There is an appreciation of the real exchange rate through nominal exchange rate appreciation.Under a fixed exchange rate regime, the central bank must loosen monetary policy to cause real exchange rateappreciation through an increase in inflation. Some level of the real exchange rate will yield an increase inimport demand sufficient to ensure full absorption of the aid dollars at the fixed nominal exchange rate.- 10 -11. Spending is defined as the widening in the government fiscal deficit net of aid thataccompanies an increment in aid:13

Spending = Δ(G-T)/ ΔAidSpending captures the extent to which the government uses aid to finance an increase inexpenditures or a reduction in taxation. Even if the aid comes tied to particular expenditures,governments can choose whether or not to increase the overall fiscal deficit as aid increases.The aid-related increases in expenditures could be on imports or domestically-producedgoods and services. Analyzing spending is important because of the natural focus on thebudget as a policy variable, and also because of the importance of tensions between the fiscalpolicy response to aid and broader macroeconomic objectives with respect to the exchangerate and inflation.12. These definitions of absorption and spending take into account, by construction, thefungibility of aid. For example, if the foreign exchange associated with a particular grant issold by the central bank, but overall net sales of foreign exchange do not increase, this doesnot constitute an increase in absorption, because no extra foreign exchange is available tofinance an increase in net imports. Similarly, if the government allocates a new grant tofinancing a domestic project that was earlier financed from different sources, this does notconstitute an increase in spending, since the non-aid fiscal deficit remains unchanged.13. Absorption and spending are distinct though related concepts and policy choices.14Ifaid comes in kind, or if the government spends aid dollars directly on imports, spending andabsorption are equivalent, and there is no impact on macroeconomic variables like theexchange rate, the price level, and the interest rate.15This paper concentrates on the moredifficult and empirically relevant case where aid dollars are gifted to the government, whichimmediately sells them to the central bank. Subsequently, the government decides how muchof the local currency counterpart to spend on domestic projects, while the central bank

The distinction between absorption and spending, in the terminology used in this paper, is one of the centralissues associated with the “transfer problem” and discussed in Keynes (1929). Keynes was concerned with theproblems involved for Germany in generating current account surpluses to pay reparations after World War I.He argued that for the fiscal authorities to accumulate the local currency counterpart to the required transferswas only part of the transfer problem—the other part being generating the net exports and therefore the requiredforeign exchange. See Milesi-Ferreti and Lane (2004) for a recent general discussion of the transfer problemand the real exchange rate.

15

Strictly speaking, this is true only if the gifted or directly imported good is one for which there was noexisting effective demand. If the good transferred was already demanded domestically, then increasing thegood’s supply would depress the price of tradables relative to non-tradables, leading to real appreciation.

- 11 -decides how much of the aid-related foreign exchange to sell on the market and spendingdiffers, in general, from absorption.16

14. Taken together, different combinations of absorption and spending out of incrementalaid define the policy response to a surge in aid inflows. Below are described the four basiccombinations of absorption and spending, together with a discussion of the macroeconomicimplications of each.

Box 1 provides a numerical example showing how the central bank andfiscal accounting works in each of these four cases.Aid absorbed and spent15. This is the textbook case, in that this is the situation assumed (explicitly or implicitly)in most discussions of the macroeconomic implications of aid inflows.17The governmentspends the aid increment and foreign exchange is sold by the central bank and absorbed bythe economy via a widening of the current account deficit. The fiscal deficit is larger butfinanced by higher aid. Spending and absorption allows an increase in government spendingby redeploying resources that had been devoted to the traded goods sector. In terms of thefamiliar national income identity Y = C + I + G + (X-M), for a given output, a fall in (X-M)allows a rise in G.16. Of course, output may not be fixed. Government expenditures may well increaseoutput, both in the short run through the effects of associated spending on aggregate demandand in the long run through the increase in the capital stock permitted by the associatedinvestment. To the extent that output can rise without a deterioration in the non-aid currentaccount, however, these increases in aggregate demand and investment could have beenundertaken without the aid flows. Aid absorption refers to the use of aid to finance the non-aid current account deficit associated with these aid-related increases in aggregate demand,investment, and output in general.

16Pratti and Tressel (2005) find that monetary policy can control the timing of absorption. Aid could also go tothe private sector directly. Here, too, if the private sector uses the dollars to directly finance imports, there isunlikely to be much macroeconomic impact. Where the private sector sells the dollars to the central bank anduses the local currency proceeds to finance domestic expenditures, similar issues will arise as in the case ofgovernment spending.17See the recent contribution from Bevan (2005).- 12 -

Box 1. Absorption, Spending, and Central Bank and Fiscal Accounting

In this numerical example, the government sells the aid dollars to the central bank and receives a localcurrency deposit at the central bank in return. Net international reserves (NIR) increase by 100 andnet domestic assets of the central bank (NDA) fall by 100 (because government deposits with thecentral bank are a negative NDA item). This places the economy in the lower-right box of the matrix.What happens next depends on whether the central bank sells the foreign exchange and on whetherthe government increases the deficit; each case is discussed in the text. The example below assumes afloating exchange rate regime. The accounting story would be the same, but the numbers and detailsdifferent, with a peg.

- 13 -17. Some real exchange rate appreciation may be necessary and indeed appropriate inresponse to a sustained higher level of aid. This is because some combination of exchangerate appreciation and (if there is excess capacity) increased aggregate demand is necessary togenerate the increased net imports that aid allows.18

18. The degree of exchange rate appreciation required to absorb the aid will in generaldepend on the structural response of the economy and the extent to which aid directlyfinances imports. For example, real appreciation would be higher to the extent that aidinflows finance expenditures on non-tradable goods rather than directly financing imports.19

On the other hand, if higher incomes feed strongly into higher import demand and if thesupply of non-traded goods responds strongly to the increase in their relative price, the realappreciation would be limited. In economies with significant unemployment and the potentialfor a quick supply response, the additional demand for non-tradable goods could induceadditional employment and production, with little increase in the price level and limited realappreciation. In the longer run, investments that increase productivity in the non-tradablesector could also reduce or even eliminate the real exchange rate appreciation.19. The mechanism for real appreciation would vary depending on the exchange rateregime. In a pure float, the central bank would sell the foreign exchange associated with theaid, causing a nominal (and real) exchange rate appreciation. In a peg, the real appreciationwould take place through a period of inflation, with the increase in government expenditurebeing accommodated by the central bank. The increase in aggregate demand and the realappreciation would again increase net import demand, leading the central bank to sell foreignexchange in defense of the peg.Aid neither absorbed nor spent20. The authorities could choose to respond to the aid inflow by building internationalreserves, and neither increasing government expenditures nor lowering taxes. In this casethere is no expansionary impact on aggregate demand, and no pressure on the exchange rateor prices.20

21. Not spending the aid may be infeasible over a longer time period, as donors need toaccount for how their assistance has been utilized. Of course, money is fungible, so that in

18The real exchange rate is generally understood in this paper to refer to the relative price of non-traded totraded goods, as a conceptual matter. When it comes to measurement, the case studies unfortunately tend tofollow the common practice of measuring the real exchange rate as a function of the nominal exchange rate andchanges in consumer price indices. It turns out for the cases under consideration that this is unlikely to make amajor difference, but further work on the correct measurement of the real exchange rate would appear justified.19One category of non-tradeable goods that might be important in this process is skilled labor; if aid raises thewages of skilled professionals, this could translate into real appreciation.20There may be second-order effects, e.g., expectations may change as a result of the central bank’s higherinternational reserve position.- 14 -principle not spending aid dollars is compatible with undertaking the projects favored bydonors, while cutting back on other budgetary expenditures. In practice, the extent to whichthis is possible would depend on the room available—both fiscally and politically—to cutexpenditures in other areas.Aid absorbed but not spent

22. Increased aid inflows can be used to reduce inflation in those countries that have notyet achieved stabilization. In such a case, the authorities can sell the foreign exchangeassociated with increased aid inflows to sterilize the monetary impact of domestically-financed fiscal deficits. The result would typically be slower monetary growth, a moreappreciated real exchange rate, and lower inflation. Aggregate demand may increase as theinflation tax declines, with a corresponding increase in private consumption and investment.The deterioration of the trade balance that often accompanies such a stabilization program isfinanced by the aid inflow.21

23. In countries that have already achieved inflation stabilization but have large domesticpublic debt, the government could use the proceeds from aid to reduce the stock of localcurrency government bonds outstanding. This would tend to result in increased privateconsumption and investment, which would raise net imports through the indirect effect ofhigher private after-tax income on import demand. The extra foreign exchange sold by thecentral bank would finance this increased demand for net imports. Again, some realexchange rate appreciation is likely to be necessary to mediate the increase in net imports.24. Whether a strategy of absorbing but not spending aid is feasible in a particularsituation depends on whether a monetary relaxation would translate into higher domesticinvestment or consumption. If there are no good private investment opportunities, forexample, an increase in credit to the private sector could result in private capital outflows ora buildup of excess commercial bank reserves at the central bank.22In addition, as with theneither-absorb-nor-spend strategy, donors’ needs to account for the use of their assistancemay make it difficult to sustain a no-spending approach.Aid spent but not absorbed25. A fourth possibility is that the fiscal deficit, net of aid, increases with the jump in aid,but the authorities do not sell the foreign exchange required to finance additional net imports.The macroeconomic effects of this fiscal expansion are similar to increasing governmentexpenditures in the absence of aid, except that international reserves are higher. Theincreased deficits inject money into the economy.

21This is the case emphasized by Buffie and others (2004).22The IMF Independent Evaluation Office (2004) argues that PRGF program assumptions that crowding in willensue from an increase in availability of credit to the private sector are often left unexamined and also often donot turn out to be correct.- 15 -26. In this case, the aid does not serve to support the fiscal expansion. This point iscentral and deserves elaboration. A transfer of real resources to the recipients country occursonly if aid finances additional net imports. Aid also serves as a way for the government tofinance its domestic expenditures, as an alternative to domestic tax revenue or borrowing,either from the public or from the central bank. It may seem, therefore, that the financing ofdomestic expenditures, such as the hiring of nurses, is an alternative use for aid, in additionto imports. But this approach to the function of aid is misleading; after all, the governmentcould always simply borrow from the central bank (i.e., print money) to finance increaseddomestic expenditures. Rather, the purpose of the aid is to provide the foreign exchangerequired to satisfy the increased demand for foreign currency resulting from the higherimport demand.23

27. Consider a thought experiment in which, for a given level of aid, the government firstdecides on the appropriate level of government expenditure and its financing. This set ofdecisions, in principle, takes into account the scope for seigniorage, the supply response toincreased fiscal expenditures, the productivity of the resulting public investment and thegeneration of higher exports that may result, and other such factors. Then, aid increases. Thething that has changed is not that the government could now productively hire, say, morenurses to fight HIV/AIDS. They could have done that before. The difference is that, whereasbefore such additional expenditures would have caused too much inflation or an un-financable deterioration of the current account through second-round increases in importdemand, now the incremental aid increases international reserves, which could be sold to payfor the higher imports. But this is the definition of aid absorption; aid that is not absorbedcannot fulfill this function.28. There are several monetary policy responses to a situation in which aid is being spentby the government but not absorbed in the economy. Absent foreign exchange sales to mopup the additional liquidity, the monetary policy options are the same as in the case of anydomestically-financed fiscal expansion. One could be to allow the larger fiscal deficits tolead to money supply increases. This is essentially monetizing the fiscal expansion andwould tend to be inflationary. In the absence of a willingness to sell foreign exchange, thenominal exchange rate will tend to depreciate as well, with a larger supply of domesticcurrency pushing up the price of foreign exchange. The resulting inflation tax helps contain

23Related to this point is an accounting issue: “domestic financing” as usually defined in the budgetary accountsis misleading as an indicator of aid usage. It may be useful to consider the following example. Suppose aid issaved entirely in the form of gross international reserves, the government builds up deposits at the central bank,and the fiscal deficit excluding aid remains unchanged. By construction, the fiscal accounts will show a shift infinancing from domestic financing (which will fall due a reduction in net central bank credit to the government)to external financing. But the aid has no macroeconomic effects in this no-absorption-and-no-spending—themoney supply, fiscal stance, interest rates and so on are unaffected (except insofar as interest earnings of thecentral bank are higher). More generally, aid that is not absorbed does not contribute to financing of thegovernment deficit in an economic sense. Thus, it would be misleading to conclude from a perusal of below-the-line financing items in the budget that aid inflows were actually financing the deficit to a greater extent thanbefore.- 16 -absorption by transferring resources from the private sector. Another response is to sterilizethe fiscally-driven monetary expansion through the issuance of treasury bills. This strategywould tend to crowd out private investment. In effect, there is a switch from privateinvestment to government consumption or investment.24

29. There are opposing effects on the real exchange rate in the spend-but-do-not-absorbcase. In a given situation the net effect will depend on specific factors, including the strengthof contrasting policy choices and other influences, such as the terms of trade. The fiscalexpansion tends to raise demand for non-traded goods, causing an appreciation; on the otherhand, it increases import demand and lowers export supply, pushing the exchange ratetowards depreciation. The net effect depends, inter alia, on the price and income elasticity ofthe country’s export supply and import demand. In addition, the central bank’s resistance toabsorption creates pressures for real depreciation. In a float, aid-related liquidity injectionswill tend to depreciate the nominal and, in the short run, the real exchange rate. Over time,higher inflation and the associated inflation tax will reduce private demand and lower the realexchange rate and absorption. Alternatively, sterilization through the sale of treasury billswill also depress private demand and hence the real exchange rate and absorption. In a peg,only the sterilization channel operates.30. Which of these combinations is best in the face of extra aid depends on many factors,including the level of official reserves, the existing debt burden, the current level of inflation,and the degree of aid volatility. For specific situations, some responses are more promisingthan others.25

• To absorb and spend the aid would appear to be the most appropriate response under“normal” circumstances. In this case there is a real resource transfer through an aid-financed increase in net imports, and a corresponding increase in public expenditures.• To absorb but not spend the aid might be an appropriate response if inflation is toohigh (possibly owing to a very expansionary fiscal policy), resources are scarce forprivate investment, or the rate of return on public expenditure is relatively low.Sustained non-spending of aid may be infeasible, however, given donor objectives,unless the budget is very fungible.

24Private investment and government expenditure could have different import intensities, which would modifythe details of the argument but not alter the main point. Similarly, the fiscal expansion may increase aggregateoutput, so it is not the case that there need be a one-for-one tradeoff between government spending and privateinvestment. But such an aggregate output expansion could have been engineered without the aid.25In general, debt sustainability is an important consideration for low-income countries. However, once thedecision has been taken to borrow internationally, all of the combinations of absorption and spending describedin this paper imply a similar rise in public external debt and in future debt service. Of course, any response thatrestricts absorption and channels the dollars into international reserves thereby makes resources available forfuture debt service. But this is equivalent to borrowing money in order to service debt, and cannot be regardedas an appropriate medium-term use of aid on these grounds.- 17 -• To neither absorb nor spend may be an appropriate short-run strategy where aidinflows are volatile or international reserves are precariously low.26Accumulatinginternational reserves while avoiding an injection of domestic liquidity through fiscalexpansion could help smooth the path of the real exchange rate if aid inflows aretemporarily high but expected to fall. However, it is not an appropriate response to apermanent increase in the level of aid, unless it is felt that Dutch disease concernsfully outweigh the benefits from the absorption of aid inflows (Appendix II).• To spend and not absorb would appear to be the least attractive option. The use of aidto build reserves while financing the increased deficit domestically is generallyunwise. Inflation can only finance a small amount of expenditure; attempts to gofurther tend raise little finance while damaging the economy.27The use of domesticsterilization is also unlikely to be a sensible medium-run strategy—it tends to shiftresources from the private to the public sector and does not allow the country tobenefit from a real transfer of resources financed by aid.III. FINDINGS FROMCOUNTRYCASES

A. The Pattern of Aid InflowsOverall net aid inflows31. Table 1 below shows the pattern of aid inflows for all the countries in the sample.Gross aid inflows are the sum of grants and loans, including both program and projectfinancing. Net aid inflows are gross inflows plus debt relief, net of amortization, interestpayments on public debt and arrears clearance.28This is the headline measure of aid inflows,since it best captures the actual inflows of foreign exchange and hence the scale of themacroeconomic challenge. All the countries in the sample received debt relief over theperiod, which, in turn, permitted the clearance of external arrears in some cases and increasenet aid inflows. Private inflows (e.g., foreign direct investment) can also be important, andneed to be considered in conjunction with public inflows.29If, for example, a surge in aid

32. All countries experienced a surge in net aid during the study period, ranging from anaverage of two percent of GDP in Tanzania to an average of 8 percent of GDP in Ethiopia.The level of net aid was also high in all countries, ranging from 7 to 20 percent of GDP. InGhana, there were two different episodes of surging aid inflows, with a sharp increase in- 19 -2001 followed by a slump the next year, followed by another surge in 2003. In all othercountries, the surge in aid was persistent, in that after the initial jump, aid inflows remainedsubstantially higher than in the pre-surge period.33. In all countries, a surge in gross aid flows accompanied the surge in net aid inflows.In Uganda, the increase in aid was almost entirely due to a surge in program assistance. InMozambique, the proportion of program and project aid remained roughly stable, while inGhana the proportion fluctuated from year to year.34. There is no case where a significant change in private inflows counteracts the patternof aid inflows. In Ghana, while net private inflows were large relative to aid, changes in theseinflows over the aid surge period were relatively small. In all other countries, private inflowswere generally smaller than aid. In Ethiopia, private inflows remained fairly stable while aidinflows surged. In Mozambique, the large jump in private inflows was due to import-financing investment on an aluminum smelting plant. In Uganda, although private inflowsincreased substantially, they followed the pattern of aid inflows.Net budgetary aid35. Net budgetary aid is the sum of budget grants and loans (including debt relief), net ofpublic debt service and arrears clearance. Net budgetary aid usually differs from net aidinflows to the economy; for example, because some aid is channeled directly to the privatesector and spent on projects outside the government budget. In this sample, however, the twoaid measures behave similarly. On average, net budget aid has increased in recent years in allfive countries (Figure 1). While the aid surge was gradual and steady in Tanzania andUganda, it was more volatile in the other three cases.36. The composition of budgetary aid changed substantially in recent years. There was aclear shift from project aid to program assistance (Figure 2a). Since the inception of thePRSP approach in 1999, donors have been increasingly willing to channel their assistance tothe recipient country’s general budget. This eases administrative and institutional constraintsin recipient economies, and gives recipient countries more flexibility in spending the aid.30

30For example, in 2001, over 1200 donor-funded projects were being implemented in Tanzania; managing andcoordinating such a large number of projects was a challenge for the authorities.- 20 -37. However, there is no obvious shift from loans to grants except in Ghana (Figure 2b).This distinction is potentially important because loans add to debt service costs in the futureand therefore have implications for debt sustainability, while grants do not. On the otherhand, there is some evidence that grants may have an adverse impact on the government’srevenue collection, while loans may have a positive impact.31

B. Macroeconomic Context38. Growth was generally robust in all countries both before and during the aid-surgeperiod, although exogenous shocks set growth back in some years (Table 2). Devastatingfloods reduced Mozambique’s growth rate in 2000, a drought reduced Tanzania’s growth ratein 1999, and severe drought caused a two-year contraction in Ethiopia. Three of the samplecountries—Ethiopia, Tanzania and Uganda—kept a tight curb on inflation, both before andduring the aid surge period. In Mozambique, however, the aid surge coincided with a sharpincrease in inflation. Ghana’s inflation was high and volatile before and during the aid-surgeperiod. The private investment-to-GDP ratio was mostly stable in the sample. In Ethiopia andTanzania, the average private investment during the surge period declined slightly relative tothe pre-surge average. In Uganda, it increased in the surge period. In most countries, theaverage public investment-to-GDP ratio was higher during the aid-surge period.Figure 2. Changes in Composition of Budgetary Aid(as a percent of total gross aid)Source: IMF Staff ReportsFigure 2a. Shift Towards Program Aid0.00.10.20.30.40.50.6GhanaMozambiqueTanzaniaUgandaPre-Aid Surge AverageAid Surge AverageFigure 2b. No Obvious Shift TowardsGrants0.00.10.20.30.40.50.60.70.8EthiopiaGhanaMozambiqueTanzaniaUgandaPre-Aid Surge AverageAid Surge Average- 22 -

1/ Mozambique lacks reliable data on private investment.Table 2. GDP Growth, Inflation and Private Investment(All figures in percent)- 23 -C. Real Exchange Rate and Dutch Disease39. Domestic expenditures financed by aid inflows may potentially lead to real exchangerate appreciation and squeeze export industries.32Table 3 summarizes movements in thenominal effective exchange rate and the real effective exchange rate.40. It is immediately apparent that a Dutch disease effect on exports via real appreciationis absent in all five countries. During the years in which aid inflows surged, there is typicallya depreciation of the real effective exchange rate, ranging from 1.5 percent (Mozambique,2000) to 6.5 percent (Uganda, 2001).33Ghana observed a small real appreciation in bothepisodes of surging aid inflows (Figure 3).41. A real depreciation in the face of surging aid inflows may indicate (i) structuralfeatures of the economy such as a rapid supply response to aid expenditures or high importpropensities, though this would tend to mitigate the appreciation rather than cause adepreciation; (ii) a fiscal and monetary policy stance that leans against real appreciation; or(iii) other exogenous events, notably a negative terms of trade shock. Subsequent sectionsconsider the first two explanations. With respect to the latter, two countries in the sample,Ethiopia and Uganda, were hit by significant negative terms of trade shocks during the aid-surge period. However, as shown in Box 2, even in these cases the incremental aid flowswere much larger than the scale of the terms of trade shocks.42. Consistent with real depreciation, export performance was strong in most of thesample, especially Mozambique and Tanzania. In Ghana too, export performance was strongdespite a stable real exchange rate. In both countries that were affected by the decline incoffee prices, real depreciation helped export performance. In particular, non-traditionalexports grew strongly, and increased as a proportion of total exports, enabling robust exportgrowth in Ethiopia and moderating the decline in exports in Uganda.

32See Appendix II for a discussion of the theoretical and empirical literature on Dutch disease.33These real effective exchange rate (REER) indices are based on nominal exchange rates and CPI inflation inthe target country and its trade partners. Lack of data prevents supplementing these indices with the REERmeasured by unit labor costs, or the REER measured as the price ratio between non-tradeables and tradeables.- 24 -

It is possible to disentangle the terms of trade effect from the aid inflows effect for the two countriesin the sample that were affected by a significant terms-of-trade shock during the aid-surge period:Ethiopia and Uganda. In both Ethiopia and Uganda, the main export commodity is coffee. A sharpand prolonged decline in world coffee prices caused a deterioration in the terms of trade for bothcountries, and in each case this deterioration coincided with surging aid inflows.

The table contains estimates of the loss in dollar inflows through net exports resulting from the terms-of-trade shock, and compares it with the increase in dollar inflows due to the surge in aid. In thiscalculation, year t quantities of exports and imports are fixed at the level of year t-1. This yields acounterfactual series for exports and imports; the difference between this series and the actual data onexports and imports is taken as the terms-of-trade effect.

In both cases, in the first year the incremental aid inflow dominated the negative effect from theterms-of-trade shock. This is also true of the average over the aid-surge period. Nonetheless, in bothcases there was a nominal and real depreciation.

- 27 -D. Was Incremental Aid Absorbed?43. Increased aid inflows must contribute to a deterioration of the non-aid current accountif a real resource transfer is to occur. Hence this paper measures absorption as the ratio of thenon-aid current account deterioration to the increment in aid.44. Following the framework in Section II, Table 4 decomposes the increment in aid ineach country into the change in the non-aid current account, the change in the rate of reserveaccumulation, and the change in the non-aid capital account. The increase in net imports (andhence the change in the current account) measures the extent of absorption, while the rate ofreserve accumulation measures the extent to which the monetary authorities curb absorption.45. In three countries, the aid led to some deterioration of the non-aid current account.However, this deterioration was typically modest in comparison to the incremental aidinflow. Only in Mozambique was over half the incremental aid inflow used to finance netimports. In Tanzania and Ghana, the non-aid current account actually improved by 2 and10 percentage points of GDP, respectively, implying that the incremental aid was notabsorbed. In all countries, the surge increased the rate of reserve accumulation. This patternis consistent with the failure of the real exchange rate to appreciate in line with the surge inaid inflows, as detailed in the previous subsection.46. Finally, in all countries, part of the aid increment was lost through reductions in therate of capital inflow. In Ghana, the deterioration in the non-aid capital account exceeded theentire increment in the aid inflow. In Tanzania and Uganda, the reduction in the rate of non-aid capital inflows was comparable to the aid surge. Some short-run movements in the non-aid capital account could reflect lags between foreign exchange being made available forabsorption and the actual increase in imports that comprises absorption.34However, thiswould not seem to be an adequate explanation for the more sustained changes observed in thesample.35

47. Were the reductions in capital inflows a result of the aid surge itself? If so, the aidinflows did not serve their intended purpose of promoting absorption. In general, the non-aidcapital account might be expected to evolve exogenously; there is no compelling theoreticalreason for net capital inflows to respond positively or negatively to a change in aid.However, capital outflows may be triggered by an aid surge in certain circumstances—inparticular, when the authorities attempt to absorb but not spend, channeling aid to the private

34For example, consider a case in which government expenditures raise wages for a set of workers. Thisincreases their demand for imports. However, when they purchase dollars from the central bank, they do notimmediately spend them on imports, but in the first instance, deposit them in dollar accounts held with domesticcommercial banks. This would count as a deterioration in the non-aid capital account (due to an increase incommercial banks’ net foreign assets). Subsequently, when they spent the dollars on imports, there would be acorresponding improvement in the non-aid capital account.35In some countries, large errors and omissions in the balance of payments accounts could be partly responsiblefor measured fluctuations in the capital account.- 28 -sector through the financial system by reducing the stock of domestic bonds outstanding. If,perhaps because of poor investment opportunities at home, private investors preferred toinvest abroad, a deterioration of the capital account could result. As the discussion in the nextsection reveals, none of the countries pursued a policy of channeling aid to the private sectorthrough the financial system. It would thus appear unlikely that such a policy resulted in thereduction in capital inflows observed during the aid-surge period.

- 29 -48. Aid inflows could also cause a capital outflow if they led the authorities to pursue anexcessively loose monetary policy. Aid-related fiscal spending tends to increase the moneysupply. If the authorities allow this to lead to excessively low interest rates and excessliquidity in the banking system, capital outflows could result. As discussed in the nextsections, aid inflows to Tanzania were associated with periods of relatively loose monetarypolicy, and this may have contributed to the slowdown in capital inflows. Direct evidence isscarce, however.49. In Ghana, the reduction in capital inflows seems to have been associated not with theaid surge but with macroeconomic disarray. Following a negative terms of trade shock andwith reserves almost depleted, non-aid capital inflows fell sharply in 2000 and again in 2001.In 2000, the exchange rate weakened sharply and inflation shot up. With an aid surge in2001, the authorities were able to avoid devaluing the exchange rate. In this case, the aidinflows likely kept absorption higher than it would have been.E. Was Incremental Aid Spent?50. Incremental budgetary aid is spent, by definition, to the extent that it leads to anincreased fiscal deficit net of aid. The government can spend aid directly by increasing publicexpenditures, or indirectly by lowering taxes (because aid is then transferred to the privatesector). This section examines whether the increase in aid was spent and explores theimplications of aid volatility for spending patterns. The evidence on spending incremental aidis summarized in Table 5.51. Three countries (Mozambique, Tanzania and Uganda) spent most of the additionalforeign assistance. In Mozambique, public expenditures actually increased more, on average,than the increment in net aid inflows, leading to a substantial widening of the fiscal deficitnet of aid. A variety of factors helped these countries spend the incremental budgetary aid.Because these countries had attained macroeconomic stability in the mid-to-late 1990s beforethe aid surge, reducing domestic financing of the budget deficit was not a major goal.Similarly, retiring domestic public debt was also not a key objective as these countries hadrather low domestic financing of the deficit as well as domestic debt and debt service prior tothe aid surge (Table 6). They had strengthened their expenditure management systems, partlybecause of the HIPC Initiative, which helped them spend most of the incremental aid thatthey received as program assistance.36To the extent that these countries spent the aidincrements, the additional spending was concentrated on capital and poverty-reducingexpenditures.